Nealon Energy Corporation engages in the acquisition, exploration, development, and production of natural gas and oil in the continental United States.

To finance the new facility. Nealon has $30 million in profits that it will use to finance a portion of the expansion and plans to sell a bond issue to raise the remaining $60 million. The decision to use so much debt financing for the projeot was largely due to the argument by company CEO Douglas Nealon Sr, that debt financing is relatively cheap relative to common stock (which the firm has used in the past).

Company CFO Doug Nealon Jr. (son of the company founder) did not object to the decision to use all debt but pondered the issue of what cost of capital to use for the expansion project. There was no doubt that the out-of-pocket cost of financing was equal to the new interest that must be daid on the debt.

SAME BALANCE SHEET OF BONDS/60% and COMMON STOCK/60%

The firm currently has one issue of bonds outstanding. The bonds have a par value of $1,000 per bond, carry a coupon rate of 7 percent, have 13 years to maturity, and are selling for $1,040. Nealon's common stock has a current market price of $32, and the firm paid a $3,00 dividend last year that is expected to increase at an annual rate of 8 percent for the foreseeable future.

• What is the yield to maturity for Nealon's bonds under current market conditions?
• What is the cost of new debt financing to Nealon based on current market prices after both taxes (you may use a marginal tax rate of 23 percent for your estimate) and flotation costs of $25 per bond have been considered? Note: Use N= 13 for the number of years until the new bond matures.
• What is the investor's required rate of return for Nealon's common stock? If Nealon were to sell new shares of common stock, it would incur a cost of $2.00 per share. What is your estimate of the cost of new equity financing raised from the sale of common stook?
• Compute the weighted average cost of capital for Nealon's investment using the weights reflected in the actual financing mix (that is, $30 million in retained earnings and 580 million in bonds).
• Compute the weighted average cost of capital for Nealon where the firm maintains its target capital structure by reducing its debt offering to 40 percent of the $90 million in new capital, or $36 million, using 530 million in retained earnings and raising $24 million through a new equity offering.
• If you were the CFO for the company, would you prefer to use the calculation of the cost of capital in part d or e to evaluate the new proieot? Why?